F2 - M1 - Revenue Recognition Introduction

Question 1

When can you recognize revenue and when can entities not use the revenue recognition standard?

Answer 1

You recognize revenue when selling a good or performing a service. You use these standards for all entities unless one of the entities uses another standard to recognize revenue. Other standards cover

Leases

Insurance

Non warranty guarantees and

financial instruments.

Question 2

For revenue recognition, what is the “ISTAR” acronym?

Answer 2

This is the five step approach for when an entity should recognize revenue.

I - Identify the contract

S - Identify the separate performance obligations in the contract

T - Determine the transaction price

A - Allocate the transaction price to the separate performance obligations

R - Recognize revenue when or as the entity satisfies each performance obligation.

Question 3

Under “I” of “ISTAR” how is a contract enforceable?

Answer 3

The contract can be either verbal, written, or implied.

Question 4

What are some of the criteria for identifying a contract?

Answer 4

• All parties have approved the contract and have committed to perform their obligations.
• Rights of each party regarding contracted goods or services are identified.
• Payment terms can be identified. (ex: I promise to pay you this much after delivery of x).
• Contract has commercial substance. Ex: basically if the future cash flows have changed because of this contract, then you have commercial substance.
• It is probable that the entity will collect consideration under the contract. (Does not mean there won’t be bad debt, just that the party would have not gotten into the contract if they thought they were not getting paid).

*

Question 5

If all of the criteria for a contract are met, when is the contract performed? At inception? What is the exception?

Answer 5

Yes, if all criteria are met, the contract should be performed at inception, unless their is a significant change in the contract.

Question 6

For the combination of contracts, how should these be handled?

Answer 6

When two or more contracts are entered into with the same customer the contracts should be combined and accounted for as a single contract if:

The contracts are negotiated as a package with a single commercial objective.

Consideration for one contract is tied to the performance or price of another contract (they do not operate solo, they are joined at the hip); or

the goods/services promised represent a single performance obligation (all contracts combined satisfy one thing).

Question 7

Let’s say that the contract did not meet any of those conditions, but consideration has been paid to the seller. Can the entity recognize revenue?

Answer 7

The entity can only recognize revenue under a contract that does not meet the criteria in these two situations:

• The consideration is nonrefundable - They agree that the amount received will not be refunded.
• There are no remaining obligations to transfer/goods or services, or the contract has terminated.

If these are met then you can recognize revenue, if they are not met, then you have to keep it as a liability (unearned revenue).

Question 8

What is a contract modification? Does this create a new contract?

Answer 8

A contract modification is when the contract has a change to it (normally the price or scope or both approved by both parties).

New contract - only if the scope increased due to new goods or services. Like building a pool on top of the agreement of building a home. Or the price increases

A modification is if it is not a major change, and they will adjust revenue to reflect the change in the transaction price.

Question 9

In S of ISTAR what are the separate performance obligations?

Answer 9

This is a promise to transfer a good or service to a customer. The transfers can be either

Individual goods or services, or one bundle of goods or services that are distinct; or

a series of goods or services that are basically the same and are transferred in the same manner.

Remember, if one good or service is not distinct from other goods or services, they will be combined to one single performance obligation.

Question 10

What are the two criteria needed for an order to be distinct?

Answer 10

Promise to transfer the good or services is separately identifiable form other goods or services in the contract (ex: there are five things in the contract and they are all separate from one another); and

Customer can benefit either from the good or service independently or when combined with the customer’s available resources. (So if they got one item out of the five, and that one item the customer can benefit from without the others, then this is distinct.)

Question 11

What are the two ways a good or service can be separately identifiable?

Answer 11

The entity does not integrate the good or service with other goods or services in the contract - You hire a firm to design the blueprint of your home and build the home. Those are so intertwined, that they are on obligation.

The good or service does not customize or modify another good or service in the contract

The good or service does not depend on or relate to other goods or services promised in the contract.

Question 12

What are some of the factors that make the goods or services not separately identifiable?

Answer 12

• Good or services are highly interrelated or interdependent.
• Entity provides goods or services that bundle with other goods and services, which makes them all one performance obligation.

Question 13

What is the T in ISTAR?

Answer 13

This is the transaction price. This is what the entity expects to receive for their goods or services.

Question 14

In determining the transaction price, what are the four things we need to consider?

Answer 14

Variable consideration - This is more of an estimation of how much you will get.

Significant financing - Payment terms and loan amounts. If there is no loan, you have to use the discount rate and bring it back to the present value. Not needed, if you pay back in one year.

Noncash considerations - Pay you in something other than cash. Consideration is the fair value of the item. Now if you offer incentives to the customer for paying early, like knocking down a few bucks, then you just reduce the transaction price if they do it.

Any consideration payable to the customer - These are any rebates or incentives.

Question 15

For variable consideration, how should you determine how much you should recognize in revenue? What does the FASB think of when estimating revenue?

Answer 15

Use either the expected value which sums probability-weighted amounts. So this would be like a weighted average, 20% its 20k, 30% it’s 30k, and take the average.

Or, use the amount that it is most likely to be. So if it is 70% likely that it will be 35k, use that number.

So the FASB says use an amount that you know you will not reverse later. So if you put 30k, you better think that you will actually get 30k. They don’t want you writing down that amount because you didn’t get the total.

Question 16

So for significant financing, what if you get into an installment agreement, where the seller says no interest on the sale? How do you record the revenue for that sale? Is there interest?

Answer 16

The FASB does not really like the no interest policy, they believe you should not be borrowing money for free. So if there is no interest rate, you have to use the discount rate to discount that total to today’s present value.

So if you sell someone a table where they have three years to pay it back at no interest rate, you need to find the discount rate. So if the discount rate is 8% and you sold it for 4k. The PV would be (4,000*1/(1.08)^3) = 3,175. The difference between the 4,000-3,175 is the interest per the three years.

Question 17

What is the A in ISTAR?

Answer 17

This occurs when you have multiple performance obligations and one price, so you want to allocate the price among those performance obligations.

Question 18

What’s allocating the transaction price to the performance obligations of a contract?

Answer 18

If there are separate performance obligations, then you need to allocate the transaction price, any discounts, variable considerations, change in transaction price

Question 19

What is the stand alone selling price for each performance obligation?

Answer 19

You should look at each performance obligation and find out what it’s stand alone selling price would be. Basically what would the price be if you sold it by itself.

Once you have those, the total transaction price should be allocated among the standalone prices for each performance obligation.

Question 20

For the stand alone selling prices, give me an example of a discount?

Answer 20

So let’s say you buy a cell phone. You not only buy the phone but you bundle and buy the phone, a plan, and accessories. Each of those items stand alone have a cost, but when you bundle, they give you a better deal so the amount is less.

The amount less that you paid compared to the total of the stand alone values is called the discount you got.

Question 21

For variable consideration, how should you allocate this in the contract price?

Answer 21

It is more common sense, but here are the three situations:

• If it is applicable to the entire contract, allocate among the entire contract.
• If it is due to an individual performance obligation within the contract, apply to that.
• If it is a distinct good or service within a single performance obligation, apply to that.

Question 22

What do you do if the transaction price changes after the contract at inception?

Answer 22

Two scenarios:

• If the transaction price changes after contract inception, the allocation will not change that you originally used, you would just use the new contract price but the same allocation. This would only work if the contract price change, not the stand alone selling prices.
• If the stand alone selling price changes, you use the price at inception and stick with it. No changes.

Question 23

For the R in ISTAR, what are the ways obligations may be satisfied?

Answer 23

They can either be satisfied over time or at a point in time.

Over time - This is when you recognize over time, like over three years for example. The the three year service contract for example.

Point in time - This is when you are able to recognize all of the revenue at one point and time. You went from recognizing zero to 100%. It is a one and done.

Question 24

What are some ways it is satisfied over time?

Answer 24

An entity enhances an asset that a customer controls. An example of this is installing the latest antivirus on your computer for a charge. This could be an annual service contract.

Customer receives the benefits of the entities performance as the entity performs it. This is like a subscription service.

Entity does not make an asset with an alternative use to the entity. Not basic inventory. This is like them building something for you specifically and they cannot sell it to anyone else.

Entity must be able to measure progress toward it’s completion. Progress can be measured using the output or input method. You have to be able to do this to recognize revenue over time. You can use the output or input method.

Question 25

What is the output method?

Answer 25

This type of method is where you compare what you have already completed, to what you still have left to complete, and that ratio gives you how much revenue you can recognize. * Examples include: units produced. I have made and delivered 5,000 out of the 10,000. * Time elapsed. You have a service contract where one year passed out of the five. * Milestones, surveys of performance, and appraisals of results achieved. Not sure what these are, but it is based on what has been completed.

Question 26

What is the input method?

Answer 26

This is based on the labor or inputs that are put into a project, not necessarily what has already been completed. Think of a CPA firm where the time you put in is billed to client. Or a gym.

Question 27

What is revenue that is satisfied point in time?

Answer 27

This is like when you go to a grocery store, buy some items, and the transfer happens in real time. It happens at one point in time, not over a period. Things that show the customer took control: Customer accepted the asset, entity has right to payment, entity transferred possession of the asset, customer has legal title and risk of asset.

Question 28

When it comes to presentation of of a contract where you performed your obligation but have not billed the client due to a stipulation or just haven't, how is that presented?

Answer 28

If you have not billed the customer yet, but performed the service obligation, that shows up as a contract asset with a credit of revenue. Once you bill the client you would record the cash and get the contract assets off your books as a credit.

Question 29

What is a contract liability, and how is that presented on the balance sheet?

Answer 29

So this is more when, you send out a bill to get paid, but you have not performed the service or shipped the goods. Due to this, you would debit a receivable and credit a contract liability. Once you perform the request, then you remove the liability off of your books. Also, if the customer owes consideration to the entity but has not yet paid, we will still book a receivable, but also an unearned liability account as well.

Question 30

For construction contracts, what are some of the ways the revenue can be recognized?

Answer 30

One way is to divide the total costs incurred to the total project costs, and that is what you recognized as revenue. So, if you put 100,000 in costs but the project costs 1,000,000. That is 10% completion so you recognize 10% as revenue.

Question 31

What criteria need to be met for construction contracts to be recognized over time?

Answer 31

* Entity creates or enhances an asset that the customer controls as the asset is created or enhanced. * Entity is not creating an asset with an alternative use to the entity, and has an enforceable right to receive payment.

Question 32

Are long term construction contracts using input or output methods?

Answer 32

Input method to recognize revenue over time. But you can use output if reasonable.

Question 33

For construction contracts, how do you recognize revenue over time?

Answer 33

percentage of estimated total income either that incurred costs to date or other acceptable measure toward completion.

Question 34

For the balance sheet, how is contract revenue recognized?

Answer 34

When recognized over time: * Construction costs and estimated gross profit earned are accumulated in the construction in progress account (an inventory account). So for example, you are just taking all of your costs and your expected gross profit, and accumulating this account. * Billings on construction are accumulated in the progress billings account (contra-inventory account). This is an account where you progress bill your client, and that amount gets recorded in this account. These get netted together for the balance sheet presentation.

Question 35

What are the other balance sheet accounts that may need to be shown for contract assets?

Answer 35

Current Assets Accounts: * Due on accounts receivable - These are the amounts you billed that is owed to you * Costs and estimated earnings of uncompleted contracts in excess of progress billings. If this criteria is met, then we will have an asset. Current Liability Account: * Progress billings in excess of cost and estimated earnings on uncompleted contracts. If this is the case you would have a liability instead of an asset.

Question 36

What is the formula for computing construction revenue over time.

Answer 36

Step 1: Contract Price - Estimated total cost = Gross Profit Step 2: Total cost to date/ total estimated cost of contract Step 3: Step 1 * Step 2 = PTD (Profit to date) Step 4: PTD at current FYE (PTD at beginning of period)/ Current year to date GP

Question 37

What are the journal entries for over time method?

Answer 37

To record costs incurred: (same for both over time and point in time) DR: Construction in progress CR: Materials, cash, etc. Journal entry to record billings on contract: (same for both over time and point in time) DR: Accounts receivable CR: Progress billings on construction contract Journal entry to record payments received: (same for both over time and point in time) DR: Cash CR: Accounts Receivable To record gross profit during construction: (Over time only) DR: Cost of long term construction contract DR: Construction in progress CR: Revenue from LT construction contracts CIP > Progress Billings: Current asset (costs of uncompleted contracts in excess of progress billings) - (Same for both methods) Progress Billings > CIP: Current liability (progress billings on uncompleted contracts in excess of costs) - (Same for both methods) Main difference CIP includes costs incurred and estimated gross profits for over time method. CIP only includes costs incurred for point in time. Journal Entry to close construction accounts - Over time method: DR: Progress billings CR: Construction in progress Journal entry to close billings to revenue: Point in time method: DR: Progress billings CR: Revenue Journal entry to close construction in progress to expense: DR: Cost of LT construction contract CR: Construction in progress

Question 38

For construction contracts, do you recognize losses right away?

Answer 38

Yes, they are recognized immediately in the year it is discovered. They are automatically moved to 100% completion. You also to adjust any profit that you recorded in prior years. So for example, is you had gross profit of 600 in years 1 and 2, and then in year 3 you have a loss of -200. You have to recognize a loss of -800 to get your amount to be -200.

Question 39

What is the difference between estimated total costs and estimated costs to complete?

Answer 39

Estimated total costs - these are costs for a long term contract from inception to completion. For example, if this is a three year project, these are the total estimated costs from year 1, 2, and 3. Estimated costs to complete - these would be added to costs incurred to date to arrive at estimated total costs. So if you already completed year 1 and 2, these are the costs of year 3 to get the total costs.

Question 40

Can construction projects be point in time?

Answer 40

Yes, if they do not meet over time, then they are. Big takeaway is that the customer pays upon completion.

Question 41

How is the point in time method presented on the balance sheet?

Answer 41

Construction contracts are accumulated in the construction in progress account (an inventory account) Billings on construction are accumulated in the progress billings account (a contra inventory account). These netted are shown in the balance sheet. Current Assets Accounts: * Due on accounts receivable - These are the amounts you billed that is owed to you * Costs and estimated earnings of uncompleted contracts in excess of progress billings. If this criteria is met, then we will have an asset. Current Liability Account: * Progress billings in excess of cost and estimated earnings on uncompleted contracts. If this is the case you would have a liability instead of an asset.

Question 42

Can construction projects be point in time? What are some examples of this?

Answer 42

Yes, this would be when a customer does not have control of the asset, and pay the full price upon completion. You recognize no revenue until the project is completed, unlike the revenue over time method.

Question 43

If you lose money on the contract, do you have to record a 100% loss on point of time method?

Answer 43

Yes, same as over time. You just don't have to reverse profits from prior years since you recognize profits at the end.

Question 44

What is an incremental cost and an example of this?

Answer 44

This would be a cost that was required to get the contract. So think, if you incurred a bunch of costs in a acquiring a contract that you otherwise would have not needed to incur, that is an incremental cost. Once you know that these were the costs needed in acquiring a contract, those costs are capitalized and amortized.

Question 45

What are the criteria needed for costs used to fulfill a contract to be capitalized?

Answer 45

* Relates directly to a contract * Generate or enhance the resources of the entity. * Are expected to be recovered. Costs to be expensed include: * Selling, general and administrative costs. * Wasted labor and materials costs * Costs tied to satisfied performance obligations

Question 46

What are the criteria for a modification to result in a new contract vs a modification?

Answer 46

If the scope increases due to the addition of distinct goods or services or; The price increases appropriately reflects the stand-alone selling prices of the additional goods/services.

Question 47

What is the difference between an agent and a principle?

Answer 47

Agent - This is someone that arranges another party to provide a good or service to a customer. Think of a travel agency that books flights for you. You pay them them the total fee, and they keep a commission. Principal - Entity controls the goods or services before it goes to a customer.

Question 48

What is a repurchase agreement and what are the three main types?

Answer 48

This is when you sell an asset, but you have the option to repurchase it at a later price. Three types: * A entity's obligation to repurchase the asset (a forward); * An entity's right to repurchase the asset (a call option); * An entity's obligation to repurchase the asset at the customers request (a put option).

Question 49

For forward and call options, what are the two scenarios that determine what type of accounting they will use?

Answer 49

If they have to repurchase the price for less than the original selling price (it will be a lease); or If they have to repurchase for equal to/more than the original price (it will be a financing arrangement).

Question 50

If it is a financing arrangement, how will the entity's accounting look for this arrangement?

Answer 50

They must recognize the asset; Recognize a financial liability for any consideration received from the customer; and Recognize as interest expense the difference between the amount of consideration received from the customer and the amount of consideration to be paid by the customer.

Question 51

For the financing agreement, can you provide an example?

Answer 51

So lets say that you sell something for 350,000 dollars, and you have a call option to buy it back for 385,000 by the end of the year. You decide not to buy it back. Here are the entries. When Purchased - DR: Cash - 350,000 CR: Financial Liability - 350,000 To record interest because remember, no free money: DR: Interest Expense - 35,000 CR: Financial Liability - 35,000 To record the revenue since you did not purchase: DR: Financial Liability - 385,000 CR: Revenue - 385,000

Question 52

For put options, if the customer makes the entity buy back the asset for less than the original selling price, how will the entity account for that transaction?

Answer 52

* A lease (if the customer has a significant economic incentive to exercise the right); or * A sale with a right of return (if the customer does not have a significant economic incentive to exercise the right). - Think of this more as any store. You will buy the goods, and most will keep it, but some might return it.

Question 53

For put options; if the repurchase price is equal to or greater than the original selling price, the entity accounts for the contract as what?

Answer 53

Either financing arrangement (if the repurchase price is more than the expected market value of the asset); A sale with a right of return (if the repurchase price is less than or equal to the expected market value of the asset and the customer does not have a significant economic incentive to exercise the right).

Question 54

What is a bill and hold arrangement?

Answer 54

This is when a entity bills a client for a product, but the entity holds the item instead of shipping it to them. They normally cannot recognize revenue on these items until they ship or deliver the goods.

Question 55

What criteria need to be met for an entity to recognize revenue on a bill and hold arrangement?

Answer 55

* There has to be a substantive reason for the arrangement. (For example: The customer asked for this arrangement because they do not have space for the item). * Product has been separately identified as belonging to the customer. (It cannot be given to anyone else, it is marked only for them.) * Product is currently ready for transfer to the customer. (For example: If the customer says they actually want the product now, instead of waiting till the original arrangement, then product has to be ready to go. Has to be ready to ship right away). * Entity cannot use the product or direct it to another customer. Has to be saved for that customer.

Question 56

What is consignment, and when is revenue recognized for consignment?

Answer 56

This is when the owner of goods, gives it to a dealer or distributor to sell for them. The owner has control of the goods. The revenue is recognized in two situations: * When the dealer of distributor sells the goods to a customer; or * The dealer or distributor obtains control of the product and pays the original owner for those goods.

Question 57

How does accounting for warranties work?

Answer 57

It depends on if you can purchase the warranty separately. If it can be purchased separately, then it is considered a distinct service and count as a separate performance obligation. You have to allocate a portion of to overall transaction price to that obligation.

Question 58

What is a refund liability?

Answer 58

This is the amount of revenue that you think you will have to give back to the buyer. It is the amount that you believe you are not entitled to receive. So, if you sell something for 100, and you think that you will have to give back 10 dollars of it. 90 would be revenue and the 10 would be a refund liability.